International Diversification
Chapter 25
McGraw-Hill/Irwin
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Background
Global market
US Market is 40% - 49% of all markets
Improved access & technology
New instruments
Emphasis for our investigation
Risk assessment
Diversification
25-2
Issues
What are the risks involved in
investment in foreign securities?
How do you measure benchmark
returns on foreign investments?
Are there benefits to diversification in
foreign securities?
25-3
Foreign Exchange Risk
Foreign Exchange Risk
Variation in return related to changes in
the relative value of the domestic and
foreign currency.
Total return = investment return & return
on foreign exchange
It’s not possible to completely hedge a
foreign investment.
25-4
Returns with Foreign Exchange
Return in US is a function of two factors:
1. Return in the foreign market
2. Return on the foreign exchange
25-5
Returns with Foreign Exchange: Example
Condition: U.S. Investor invests $10,000 in the
British Market
Initial Conditions:
Initial Investment : $20,000
Initial Exchange: $2.00/ Pound Sterling
Initial Investment in Pound Sterling: 10,000
Risk Free Rate in U.K.: 10%
Future Value in Pound Sterling: 11,000
25-6
Returns with Foreign Exchange
Pound Depreciates to $1.80
11,000 * 1.8 = $19,800
Return in US$ (-200 / 20,000) = -1%
Pound Remains at $2.00
11,000 * 2.0 = $22,000
Return in US$ (2,000 / 20,000) = 10%
Pound Appreciates to $2.20
11,000 * 2.20 = $24,200
Return in US$ ( 4,200 / 20,000) = 21%
25-7
Returns with Foreign Exchange
Movements in foreign exchange can have a
major influence
From Figure 25.2
New Zealand nearly 50% of return is from foreign
exchange
Australia virtually all of the return in from foreign
exchange
Returns from U.K. and Switzerland are mostly
from returns in local currency
Both factors must be considered in
international investing
25-8
Country Specific Risk
Political Risk Services Group Ratings
Rank countries with respect to political
risk, financial risk and economic risk
Assign composite rating from very high
risk to very low risk based on the above
elements of risk
25-9
PSR Risk Variables
Political Risk Variables
Government stability, corruption etc
Financial Risk Variables
Foreign debt (%GDP), Exchange rate
stability etc
Economic Risk Variables
GDP per capita, annual inflation etc
25-10
Diversification Benefits
Evidence shows international
diversification is beneficial.
It’s possible to expand the efficient
frontier above domestic only frontier.
It’s possible to reduce the systematic
risk level below the domestic only level.
25-11
Gains From International Diversification
Int’l
Return
** *
*
*
*
*
Dom
*
Risk
25-12
Systematic Risk Level with International
Risk
Dom
Int’l
Securities
25-13
International Investment Choices
Direct stock purchases
American depository receipts
Mutual Funds
Open-end funds
Closed-end funds
WEBS
25-14
Measuring Benchmark Returns
Indexes
EAFE Index
Issues in measuring performance
Weighting
Cross-Holdings
Other possibilities
Country and Region Funds
25-15
Performance Attribution with International
Extension to consider additional factors
Currency selection
Country selection
Stock selection
Cash and bond selection
25-16